Day Four. Policymakers stare into the abyss
If you want to read something that sums up where we are, and at the same time is an advert for measured, balanced, highly-informed team reporting, read this lead article in the Wall Street Journal.
I'll sum it up: the financial crisis is gathering momentum because round one, the collapse or forced acquisition of the weakest links in the chain, hasn't been enough to stem the panic. So as well as interbank lending drying up, we now see totally solvent institutions like Goldman Sachs pressured. But the big difference is that the authorities, at least in the USA, are firefighting effectively: if they'd only regulated as aggressively as they are firefighting this would not have happened.
OK so where next? What's happening is that in the process of unwinding complex and risky derivatives contracts the financial institutions are "deleveraging": this means they are doing the equivalent of a rapid paydown of several credit cards at once out of your salary cheque. If I do this, personally, it leaves me short of cash: no takeaway curry, no wine dearer than a tenner, no cabs, no stripy shirts from Etro of Bond Street. In short, eventually, this will impact on demand in the real economy.
Already I would imagine the impact of seeing HBOS rush into the arms of LloydsTSB will have impacted on consumer confidence, especially among the older generation that knows and fears where banking crises can lead. But this is just the beginning.
Because, just as the consumer economy runs on Visa and Mastercard, the world economy has learned to run on leverage. It's not just about the amount of ready cash but its "readiness" - ie liquidity. Because we have not (yet) had a 1930s style stock market crash, or a run on savings banks, does not mean there is no potential for a 30s style depression: it will just begin from the top and work its way down - and the next place it will hit will be highly indebted non-financial companies.
There are, from memory, about 25% of UK businesses who pay out more in interest every month than they make in profit.
In this light it is worth considering what the authorities and governments can, and cannot do. Right now it is clear, if your read the signs, that G7 governments are engaged in a co-ordinated tactical re-regulation offensive. The US SEC will ban naked short selling today and, more importantly, require disclosure of retrospective info about large short positions. This will tell us which institutions have been trying to manipulate the market to their advantage during the crisis. Since it is probably all of them it is designed to have a massive cooling effect on speculation. In this Bernanke, Paulson, Bloomberg et al (who are really calling the shots) are learning from the 1930s. They realise there is massively greater potential for derivatives trading to crash the financial markets in a "meteor-and-dinosaurs" kind of way.
They are also establishing a pattern: bailout of institutions that have mass retail impact, but always with a managerial clearout; while letting arrogantly run pure-financial institutions (eg Lehman) go to the wall. Incidentally this is a big signal also to hedge funds: guys we are too busy right now to do another LTCM-style rescue operation.
Everybody with any sense of economic history is talking not just about the 1930s but Japan in the 1990s. The last time interest rates on central bank debt were this low was in Japan in 1991 - and a decade of stagnation followed.
I conclude from their actions - Brown/Darling with HBOS and Paulson/Bernanke with AIG - that they are pretty phenomenally scared that there will now be a full scale financial crash.
Hence the 180bn liquidity pumped by central banks into the system overnight. Let's be clear what a crash would look like: right now both in the UK and the USA people's bank accounts are protected by deposit guarantee: $100,000 per account in the US, £32,000 in the UK. Both are theoretically funded by contributions from insured banks. The USA's FDIC fund currently stands around $45 bn after it cost $8bn to bail out IndyMac.
I say theoretically however because modern banking deposit insurance has never been tested in a crisis. At a time when all investment banks are sitting on their cash and refusing to trade with each other, and when the balance sheets of all retail banks except very boring ones are stressed, Anglo-Saxon depositor insurance regimes stand in danger of being exposed as yet more "necessary fiction".
Here is the danger inherent in the phrase that is being bandied about currently: "too big to fail". It implies, rightly, that there are some institutions that are too systemic for governments to avoid trying to bail out. But it may suggest that all government bailout attempts are successful. Ultimately what is "too big to fail" is the retail banking system: that is what Ben Bernanke knows because he is famous for his academic work on its collapse in the 1930s. He also knows that, once it starts failing, this is the one thing that government action cannot stop. The government cannot bail out every depositor and every pension fund in the country. When people ask what a crash looks like that is it: it is when you lose all your money.
Bernanke has written extensively about the "financial accelerator" - the ability of a banking crisis to ampilfy - rapidly - an economic downturn in the real economy:
"Just as a healthy financial system promotes growth, adverse financial conditions may prevent an economy from reaching its potential. A weak banking system grappling with nonperforming loans and insufficient capital or firms whose creditworthiness has eroded because of high leverage or declining asset values are examples of financial conditions that could undermine growth. Japan faced just this kind of challenge when the financial problems of banks and corporations contributed substantially to sub-par growth during the so-called "lost decade."
That is from a Bernanke speech last year and it perfectly outlines the transmission mechanism from today's panic-stricken atmosphere, where bystanders keep pointing their mobile phone cameras at the buildings of failing institutions just to record the moment, to a 1930s style stagnation.
If governments fail to stem the financial panic, and the real economy goes into a tailspin, that will give momentum to the currently fashionable but vacuous rhetoric on re-regulation. At present the re-regulation drive is not backed up by the visceral emotions of the 1930s, which - let's remind ourselves - saw millions of people's lives destroyed in the richest countries in the world: destroyed to the extent that even in old age they were mentally and physically scarred by the decade. However, if it comes to pass that we get mass unemployment and deflation, the quid pro quo instincts will probably be much stronger among this generation because, as we all know, deference is dead.
In this regard I will offer you one more quote from Mr Bernanke's 2007 speech:
"In the United States, a deep and liquid financial system has promoted growth by effectively allocating capital and has increased economic resilience by increasing our ability to share and diversify risks both domestically and globally."
That's what it seemed like back in the pre-historic days of last June. Today to any objective observer it reads like hubris - and Bernanke, an honest and open minded academic as well as policymaker, must recognise this.
The financial system was liquid, but it was not deep: it was tall, stacked too high, balanced on too narrow foundations. Capital was not being effectively allocated: it was being channeled relentlessly into the pockets of speculators, so much so that the history of the US economy in the 1997-2007 period will be seen as one speculative bubble after another: dotcom, housing, derivatives. And it did not increase economic resilience: the risks were shared, diversified even: but they were also systematically misallocated: junk badged as triple-A. Part scam, part self delusion, the derivatives bubble destroyed itself.
And lots of people warned it would. If this ends up destroying another generation's prosperity it will be more than just the incumbent political parties that happen to be left holding the grenade as it blows up who catch the shrapnel. It will be the all those in politics and business who colluded in the elevation of de-regulation to the status of an ideology, and propagated the truism that state intervention is always worse than a free-market solution.
When Bernanke hosted a birthday party for free-market economist Milton Friedman in 2002 he promised:
"Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve System. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."
That's what's at stake.